March 16 – Financial Times (Robin Wigglesworth, Joe Rennison and Nicole Bullock): “When Romeo impatiently hankered after Juliet, the sage friar Lawrence dispensed some valuable advice: ‘Wisely and slow; they stumble that run fast.’ It is a dictum the Federal Reserve clearly intends to live by, despite the improving economic outlook. There have been rising murmurs in financial markets that after years of the Fed being too optimistic on the economy, inflation and interest rates, it is now behind the curve. But on Wednesday the US central bank sent a clear message to markets that it is not in a hurry to tighten monetary policy.”

Yes, markets had begun fretting a bit that a sense of urgency might be taking hold within the Federal Reserve. But the FOMC’s two-day meeting came and went, and chair Yellen conveyed business as usual. Policy would remain accommodative for “some time.” The focus remains resolutely on a gradualist approach, with Yellen stating that three hikes a year would be consistent with gradualism. And three baby-step hikes a year would place short rates at 3.0% in early 2020 (the Fed’s “dot plot” sees 3% likely in 2019). It’s not obvious 3% short rates three years from now will provide much restraint on anything. As such, the Fed is off to a rocky start in its attempt to administer rate normalization and a resulting tightening of financial conditions.

Yellen also suggested that the committee would not be bothered by inflation overshooting the Fed’s 2.0% target: “…The Fed is not inclined to overreact to the possibility that inflation could drift slightly — and in the Fed’s view temporarily — above 2% in the coming months.” There would also be no reassessment of economic prospects based on President Trump’s agenda of tax cuts, infrastructure spending and de-regulation. “We have plenty of time to see what happens.” Moreover, the Yellen Fed did not signal that it is any closer to articulating a strategy for reducing its enormous balance sheet.

Ten-year Treasury yields dropped 11 bps on FOMC Wednesday to 2.49%, the “largest one-day drop since June.” Even two-year yields declined a meaningful eight bps to 1.30%. The dollar index fell 1.0%, with gold surging almost $22. The GSCI commodities index rose more than 1%. EM advanced, with emerging equities (EEM) jumping 2.6% to the high since July, 2015.

I think back to the last successful Fed tightening cycle. Well, I actually don’t recall one. Instead it’s been serial loose financial conditions and resulting recurring booms and busts. And, once again, the Fed seeks to gradually raise rates without upsetting the markets. Yellen: “I think if you compare it with any previous tightening cycle, I remember when rates were raised at every meeting, starting in mid-2004. And I think people thought that was a gradual pace, measured pace. And we’re certainly not envisioning something like that.” Heaven forbid…

In her press conference, Yellen again addressed the “neutral rate” – “The neutral level of the federal funds rate, namely the level of the federal funds rate, that we keep the economy operating on an even keel. That is a rate where we neither are pressing on the brake nor pushing down on the accelerator. That level of interest rates is quite low.”

Yellen may not believe the Fed is “pushing down on the accelerator,” yet the truck is racing down the mountain.

March 14 – Bloomberg (Claire Boston): “Companies are issuing bonds in the U.S. at the fastest pace ever… Investment-grade firms are on track to complete the busiest first quarter for debt sales since at least 1999. Firms… have pushed new issues to more than $360 billion so far in 2017, closing in on the previous record of $381 billion from 2009… That puts bond sales 14% ahead of last year’s record pace… High-yield bond offerings have also roared back after a plunge in commodity prices muted new issues last year. Junk-rated firms have sold more than $72 billion in 2017 through Monday, compared with $41.7 billion in the first quarter of 2016.”

March 16 – Bloomberg (Sid Verma and Julie Verhage): “Financial markets are telling Janet Yellen there’s more work to be done -- or else. While the Federal Reserve chair raised interest rates by 25 bps as expected Wednesday, the outlook was less hawkish than market participants foresaw, with projections for the medium-term tightening cycle largely unchanged… ‘Our financial conditions index eased by an estimated 14 bps on the day -- about 2.3 standard deviations and the equivalent of almost one full cut in the funds rate -- and is now considerably easier than in early December, despite two funds rate hikes in the meantime,’ Goldman Chief Economist Jan Hatzius and team wrote…”The Nasdaq Composite is up almost 10%, and there’s still two weeks remaining in the first quarter. The Nasdaq 100 (NDX) has gained 11.2% q-t-d, with the Morgan Stanley High Tech Index up 13.1%. Unprecedented U.S. debt issuance could see quarterly debt sales approach a staggering $400bn. And it’s not only an American phenomenon. EEM (EM equities) enjoys a 13% q-t-d gain. Basically, stocks have posted solid early-2017 gains around the world. Corporate bond markets are booming globally. A highly speculative marketplace was delighted chair Yellen examined the current extraordinary backdrop and envisaged “even keel.”

Markets some time ago moved beyond even keel. I’ll point back to chairman Bernanke’s 2013 (“flash crash”) comment that the Fed was prepared to “push back against a tightening of financial conditions.” That was the most explicit signal yet that the Federal Reserve would backstop the financial markets to the point of guarding against even a modest “Risk Off” dynamic. Markets have hardly looked back since. Indeed, Bernanke and Yellen took “asymmetrical” (ease aggressively, “tighten” timidly) so far beyond the Maestro Greenspan. It will now be virtually impossible to convince overheated markets of a return to a more even keel policy approach.

Fed policies, from Greenspan to Bernanke to Yellen, provided huge competitive advantages to bullish speculative long positions. And especially since 2013 – and particularly with the policy response to last year’s market instability – the “bears” have been basically crushed into submission/oblivion. Everyone has been forced to jump aboard the bull market. This has led to a momentous supply/demand imbalance throughout the securities markets. Too much “money” has been flooding into the markets, while an atypical dynamic ensures a dearth of willing sellers. This powerful market dislocation has granted the bulls the luxury of easily pushing the market higher with little resistance from would be sellers.

Wednesday trading saw a recurring dynamic. The prospect of a hawkish FOMC meeting outcome created the risk of event-driven market instability. The hedging of risk going into this meeting created yet another opportunity to punish those on the wrong side of trades. And it’s the unwind of hedges/shorts that (for the umpteenth time) provided buying power for higher bond and equities prices. Sellers of securities – bearish traders, risk-conscious hedgers or derivative players – at this stage of the market cycle have an extraordinarily low pain threshold. The market is steeply tilted to the benefit of one side – the long side. The bulls enjoy “strong hands” – while the much-depleted ranks of weakling “bears” have about the feeblest little “weak hands” imaginable.

And the reality of the situation is that this anomalous backdrop has a profound impact on general financial conditions. Over recent decades, securities markets evolved to assume the dominant position in Credit creation, hence for system financial conditions more generally.

It’s no coincidence that markets – sovereign bonds last year and risk assets currently – have demonstrated a proclivity for “melt-up” dynamics in the face of mounting global risks. For years now, and reminiscent of the late-twenties, the fragile backdrop has ensured that central bankers cling tightly to their extraordinary monetary stimulus and market backstop measures.

Markets were beginning to feel a little anxious that the Fed might actually acknowledge market excess. Perhaps booming markets were behind the Fed’s determination to move in March rather than wait until May. And I’ll assume that the committee believed pressing for an earlier rate increase would be interpreted in the markets as a more forceful “tightening.” It’s just not going to work that away. Overheated markets at this point will dismiss timid measures. Central banker measures have for too long rewarded greed and punished fear. Greed has grown to dominate, and greed scoffs at central bank gradualism.

The problem today is that years of ultra-loose monetary conditions have ensured everyone is crowded on the same bullish side of the boat. Tipping the vessel at this point will be chaotic, and the Fed clearly doesn’t want to be the instigator. Meanwhile, timid little baby-step increases only ensure more problematic market Bubbles and general financial excess.

It’s now an all-too-familiar Bubble Dynamic. The greater the Bubble inflates, the more impervious it becomes to cautious “tightening” measures. And the longer the accommodative backdrop fuels only more precarious Bubble Dynamics, the more certain it becomes that central bankers will approach monetary tightening timidly. Yellen confirmed to the markets Wednesday that the Fed would remain timid – still focused on some theoretical “neutral rate” and seemingly oblivious to conspicuous financial market excess. The fixation remains on consumer prices that are running just a tad under its 2% target, while runaway securities market inflation is completely disregarded.

Yellen: “So at present, I see monetary policy as accommodative. Namely the current level of the federal funds rate is below that neutral rate, but not very far below the neutral rate.”

At this point, is not apparent what it would take for the Yellen Fed to change its view. It’s worth mentioning new Minneapolis Federal Reserve Bank President Neel Kashkari’s lone dissent. From Reuters: “‘The announcement of our balance sheet plan could trigger somewhat tighter monetary conditions,’ Kashkari said, resulting in the equivalent of a rate hike of unknown size. ‘After it has been published and the market response is understood, we can return to using the federal funds rate as our primary policy tool, with the balance sheet normalization under way in the background.’”

Kashkari has a point with his focus on the balance sheet. From my perspective, reducing the size of the Fed’s balance sheet would likely prove a more effective mechanism for removing accommodation than baby-step rate increases. Somehow the Fed needs to convince the markets that again boosting the Fed’s balance sheet is completely off the table. The markets believe that QE policy has simply been placed on hold, with open-ended “money” printing available the day the markets demand a liquidity backstop. The Fed should take the opportunity to ween the market off the dangerous perception that QE is available to ensure the extinction of bear markets and recessions. It’s this momentous market perception that works to ensure baby-step rate increases have no restraining impact on Bubble Dynamics.

The Fed let another opportunity slip away. One of these days the bond market may mount a protest. European periphery bonds were none too impressive. With German yields declining five bps this week, spreads widened across the board. And the dollar… It’s worth noting the yen gained 1.9% this week. And almost $5.7bn flowed out of junk bond funds.

Fed Boosts Gold, But We Think The Narrative Is Changing - And This Factor Will Become Its Primary Driver

by: Hebba Investments.

Summary

- Speculative traders sold and shorted gold in anticipation of the Fed meeting, which was the completely wrong move.- As the Fed did what everybody expected, gold traders bought back previously sold positions in a “sell-the-rumor and buy-the-fact” moment.- Asian gold premiums remain fairly subdued despite the price move in gold.- With the Fed's move over, we think gold will now be focused on US fiscal and tax policy which we think will disappoint investors and boost gold.

The latest Commitment of Traders (COT) report showed a large drop in speculative long positions leading up to the Federal Reserve meeting, which obviously was the wrong move by speculators as gold popped after the Fed's decision on a "sell-the-rumor and buy-the-fact" moment. We think much of the rise in gold after the Fed meeting was due to this overextended short position by speculative gold traders as evidenced by the surge in shorts (and drop in longs) leading up to the meeting.

In terms of physical gold premiums, in Asia they were mixed last week as Chinese premiums surged due to tightening import restrictions by the Chinese government. In contrast, Indian premiums fell from $2.00 to $1.50 over domestic gold prices, which was attributed to Indians paying advance tax for the fiscal year (India's fiscal year ends in March).

Finally, we think there's a shift in the gold narrative. The focus is shifting from the Federal Reserve and the direction of interest rates being the primary driver to one where the US government's policy and tax positions will be carefully scrutinized by gold traders.

We will get more into some of these details but before that let us give investors a quick overview into the COT report for those who are not familiar with it.

About the COT Report

The COT report is issued by the CFTC every Friday, to provide market participants a breakdown of each Tuesday's open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. In plain English, this is a report that shows what positions major traders are taking in a number of financial and commodity markets.

Though there is never one report or tool that can give you certainty about where prices are headed in the future, the COT report does allow the small investors a way to see what larger traders are doing and to possibly position their positions accordingly. For example, if there is a large managed money short interest in gold, that is often an indicator that a rally may be coming because the market is overly pessimistic and saturated with shorts - so you may want to take a long position.

The big disadvantage to the COT report is that it is issued on Friday but only contains Tuesday's data - so there is a three-day lag between the report and the actual positioning of traders. This is an eternity by short-term investing standards, and by the time the new report is issued it has already missed a large amount of trading activity.

There are many ways to read the COT report, and there are many analysts that focus specifically on this report (we are not one of them) so we won't claim to be the exports on it. What we focus on in this report is the "Managed Money" positions and total open interest as it gives us an idea of how much interest there is in the gold market and how the short-term players are positioned.

This Week's Gold COT Report

This week's report showed a decrease in speculative gold positions as longs shed 34,066 contracts during the COT week while shorts added 9,992 contracts to the gross speculative short position. This was one of the largest drops in the total net speculative position in months - and it turned out to be dead-wrong.

The red-line represents the net speculative gold positions of money managers (the biggest category of speculative trader), and as investors can see, we saw the net position of speculative traders decrease by a chunky 44,000 contracts to 50,000 net speculative long contracts.

The red line which represents the net speculative positions of money managers, showed a big drop in bullish silver speculators as their total net position dropped by around 15,000 contracts to a net speculative long position of 68,000 contracts. While still high, it certainly is positive for contrarians as we see some of the speculative froth in silver drop.

Asian Gold Premiums Remain Mixed

As we mentioned earlier, Asian premiums remained mixed over the past week. Chinese premiums surged due to tightening import restrictions by the Chinese government as Beijing efforts to control capital outflows continued to restrict gold import licenses. While rising premiums are positive, if they are due to government restrictions we cannot give it as much of a bullish bias as premiums aren't rising to naturally increasing demand, but rather, to artificially decreased supply.

In contrast, Indian premiums fell from $2.00 to $1.50 over domestic gold prices, which was attributed to Indians paying advance tax for the fiscal year (India's fiscal year ends in March).

Meanwhile, premiums in Singapore rose to about $1.20, compared with the 90 cents to $1 range seen the week before, and prices in Japan were at a discount of 50 cents to a dollar, against the 75 cents to $1 levels in the prior week.

Our Take and What This Means for Investors

This week was an excellent example of "sell-the-rumor and buy-the-fact" as speculative traders all rushed to sell and short gold into the Fed meeting, only to be forced to cover and buy back positions as the Fed did exactly what was predicted of it. This should be a very clear lesson for those trading on already priced in news.

But we don't think all the move in gold was due to speculative trading on the Fed meeting - we think there were many traders starting to move in anticipation of US government tax and policy decisions moving forward. While a bit over-shadowed by the Fed, last week we also saw the initial budget proposal by President Trump - and it seems there is a lot of opposition by Republicans.

The budget will certainly be changed by the US Congress as we move forward, but there's a real chance of a US government shutdown in April if compromises are not reached, and with the current contention in Congress, we would not be surprised. If that happens, it would probably be very negative for the stock market and positive for gold (as chaos usually is).

If there is compromise, then we have a feeling it will not be because Congress approves most of Trump's budget (and its cuts), but rather, a big transformation of the bill as Congress approves many of the budget's spending measures but removes most of its budget cuts. Ultimately, watering down cuts and approving spending thus creating a budget which will lead to larger US déficits.

It provides no discussion of tax reform or infrastructure plans, which the White House says will be released "in coming months", likely as part of a full budget submission to Congress that we expect to be released around May.

It also includes no discussion of the Obamacare replacement plan.

The narrative has been that Wall Street has been rising because of President Trump's massive infrastructure spending and tax reform that will boost corporate bottom lines and use fiscal stimulus to boost the economy. Yet no mention at all in the budget - not good in our view for the popular narrative and that would be negative for stocks.

Last week we changed our short-term picture of gold from bearish to neutral, and this week we continue that positive shift from NEUTRAL to NEUTRAL-BULLISH on gold as the narrative changes from the Fed to the US government's budget and policy moves. We see a lot of friction and a lack of conviction by policy makers to implement the current budget and make any significant tax or infrastructure-spending moves. Since Wall Street has been rising in anticipation of that, we see the possibility of a major correction in stocks - and we think that would be positive for risk-off assets like gold.

The only reason we aren't going to BULLISH for the short-term gold picture is because we feel the new US-government focused narrative will take some time to sink in for traders. That means we could see a corrective drop in gold, but we would view that as a buying opportunity.

We remain bearish on silver for the reasons outlined last week as we see the risk-return much better in gold, but if we continue to see some of those speculative traders lower their net-long position in silver or a big drop in the price, we would be buyers of silver too as its correlation to gold would be much more attractive as a primary driver.

In summary, we are continuing to buy back some of our previously sold gold positions and we are starting to look to purchase some of our previously sold miners especially if we see a corrective drop next week. Thus we think investors should considering increasing their positions in the miners and gold ETFs, like the SPDR Gold Trust ETF (NYSEARCA:GLD), and ETFS Physical Swiss Gold Trust ETF (NYSEARCA:SGOL). For silver, we are still not ready to really begin aggressively adding to our positions in the ETF's like the iShares Silver Trust (NYSEARCA:SLV), ETFS Silver Trust (NYSEARCA:SIVR), and Sprott Physical Silver Trust (NYSEARCA:PSLV), as gold simply has a better risk-reward profile at the current time but with a further drop in silver we may consider buying back some of our previously sold positions.

A domestic political battle is brewing in the United States between President Donald Trump’s administration and the Republican Party over the president’s economic plans. Trump’s key economic positions during his campaign included his opposition to free trade deals, his promise not to cut Social Security and Medicare, and his support of large-scale infrastructure spending. These are all positions that have clashed with general Republican orthodoxy. They were also the reason that some Bernie Sanders supporters found themselves nodding in unexpected agreement with Trump’s proposed policies.We can bring one key insight to this conversation as the battle lines are being drawn. It is extremely difficult to speak of the US economy as an undifferentiated whole. The US has varied economic interests at both the regional and state levels. This makes it extremely difficult to find a one-size-fits-all policy that can fix every problem.This is not only true for the US—almost all large countries (and even some small ones) are highly regionalized. It is also not to say that national economic statistics are useless—they can be used to make important observations about the overall performance of a national economy, especially in terms of the economic power of a given country. But too often, discussion of the US economy focuses disproportionately on the national level and not enough on the regional.

What Export Patterns Tell Us

One way to illustrate how regions differ from each other is to look deeper at US exports. Readers of Geopolitical Futures’ work will be familiar with this concept: the US is the largest economy in the world by far, and yet exports account for just 12.6% of US GDP.In absolute terms, US exports are still worth more than in most countries, totaling $2.2 trillion in 2016, according to the US Census Bureau. The only other country that comes close to or surpasses the US in terms of export value is China. The latest World Bank figures put the total value of Chinese exports at $2.4 trillion.But on the whole, the US is a massive consumer economy that is not highly dependent on exports. This is true at the national level, but when US trade statistics are broken down by state, the situation is more complex.

Only 10 US states derive more than 10% of their state GDP from exports: Indiana, Kentucky, Louisiana, Michigan, Mississippi, South Carolina, Tennessee, Texas, Vermont, and Washington. Eight of these states are located either in the Mideast or the South and voted for Trump in November’s presidential election.Of these 10 states, four derive more than 4% of their GDP from exports to just one country. Michigan and North Dakota are highly dependent on exports to Canada. Texas is inordinately dependent on exports to Mexico, and Washington is heavily reliant on exports to China.

Views on NAFTA and China

Each state’s approach to trade agreements and negotiations will be defined by its own trading practices and economic focus. For states like Texas and Michigan, NAFTA is going to be a major economic and political issue. A large portion of these states’ economies—and a significant number of jobs—relies on trade across their southern and northern borders, respectively. These states also view the rise in China’s share of global manufacturing production as a potential threat, since they are manufacturing centers and China can produce goods at lower costs.On the other hand, a state like Washington, located on the Pacific coast, will be less concerned with NAFTA and more concerned with policies that would open new potential trading markets in Asia.For example, stricter trade policies with China could affect Washington’s access to the Chinese market. As such, Pacific-facing states will have different priorities than Atlantic-facing states… and these regions will have different interests than the heartland.Even states with similarly sized economies can have vastly different approaches to trade and economic policy based on their specific economic activities. Take South Carolina and Connecticut as examples. These states have similar GDP totals. However, as a percent of total US exports, South Carolina exports twice as much as Connecticut. In Connecticut, exports account for about 6% of GDP, and the state’s top trading partner is France. In South Carolina, exports account for over 15% of GDP, and the state’s top trading partner is China.South Carolina is a manufacturing state and has been affected by globalization in a much different way than Connecticut. Ironically, a study by the Mercatus Center at George Mason University ranks Connecticut dead last in terms of fiscal solvency of all US states, whereas South Carolina is ranked 18th. But such statistics observe dependencies each state develops and, therefore, speak to the individual states’ policy priorities.

A Lesson for Washington

It is extremely difficult, if not impossible, for a policymaker in Washington, DC to design a plan that will benefit both South Carolina’s manufacturing industry and Connecticut’s financial services and insurance industry. And these are just two of 50 states. Any federal official attempting to make plans at the national level must think in terms of 50 different states, or eight different economic regions, or a number of other divisions that reveal shared interests.The map below indicates the vast differences between regions just in terms of GDP.This is not a novel observation. The US Civil War was fought, in part, because different systems of economic production in the North and South created not just economic fissures, but also social and cultural gulfs so great that the country went to war. Earlier still in US history, John Adams and Thomas Jefferson lived in different economic universes, and the arguments between Federalists and Jeffersonian Democrats (and their views on economic policy) shaped and continue to shape the US’s development. The fault lines may have shifted, but the fundamental issue—the relationship between the federal government and the individual states—has never been settled.The coming battle over economic policy will feature much grandstanding and sincere promises, some of which may be fulfilled. To understand what is at stake and why certain politicians advocate certain positions, it is not necessary to parse tweets or examine individual ideology. At the international level, we always argue that imperatives and constraints shape individual leaders as well as state actors. This is just as true at the subnational level, and even more so in a republic like the United States, where representatives who do not act in the interests of their constituencies can quickly find themselves out of a job.

More economic pain is on the way.By George FriedmanChinese Premier Li Keqiang told the National People’s Congress that China’s GDP growth rate would drop from 7 percent in 2016 to 6.5 percent this year. In 2016, the country’s growth rate was the lowest it had been since 1990. The precision with which any country’s economic growth is measured is dubious, since it is challenging to measure the economic activity of hundreds of millions of people and businesses. But the reliability of China’s economic numbers has always been taken with a larger grain of salt than in most countries. We suspect the truth is that China’s economy is growing less than 6.5 percent, if at all.The important part of Li’s announcement is that the Chinese government is signaling that it has not halted a decline in the Chinese economy, and that more economic pain is on the way. According to the BBC, Li said the Chinese economy’s ongoing transformation is promising, but it is also painful. He likened the Chinese economy to a butterfly struggling to emerge from its cocoon. Put another way, there are hard times in China that likely will become worse.Chinese Premier Li Keqiang attends the opening session of the National People’s Congress at The Great Hall of the People on March 5, 2017 in Beijing, China. Lintao Zhang/Getty ImagesChina’s economic miracle, like that of Japan before it, is over. Its resurrection simply isn’t working, which shouldn’t surprise anyone. Sustained double-digit economic growth is possible when you begin with a wrecked economy. In Japan’s case, the country was recovering from World War II. China was recovering from Mao Zedong’s policies. Simply by getting back to work an economy will surge. If the damage from which the economy is recovering is great enough, that surge can last a generation.

But extrapolating growth rates by a society that is merely fixing the obvious results of national catastrophes is irrational. The more mature an economy, the more the damage has been repaired and the harder it is to sustain extraordinary growth rates. The idea that China was going to economically dominate the world was as dubious as the idea in the 1980s that Japan would. Japan, however, could have dominated if its growth rate would have continued. But since that was impossible, the fantasy evaporates – and with it, the overheated expectations of the world.

China’s dilemma, like Japan’s, is that it built much of its growth on exports. Both China and Japan were poor countries, and demand for goods was low. They jump-started their economies by taking advantage of low wages to sell products they could produce themselves to advanced economies. The result was that those engaged in exporting enjoyed increasing prosperity, but those who were farther from East China ports, where export industries clustered, did not.

China and Japan had two problems. The first was that wages rose. Skilled workers needed to produce more sophisticated products were in short supply. Government policy focusing on exports redirected capital to businesses that were marginal at best, increasing inefficiency and costs. But most importantly – and frequently forgotten by observers of export miracles – is that miracles depend on customers who are willing and able to buy. In that sense, China’s export miracle depended on the appetite of its customers, not on Chinese policy.

In 2008, China was hit by a double tsunami. First, the financial crisis plunged its customers into a recession followed by extended stagnation, and the appetite for Chinese goods contracted. Second, China’s competitive advantage was cost, and they now had lower-cost competitors.

China’s deepest fear was unemployment, and the country’s interior remained impoverished. If exports plunged and unemployment rose, the Chinese would face both a social and political threat of massive inequality. It would face an army of the unemployed on the coast. This combination is precisely what gave rise to the Communist Party in the 1920s, which the party fully understands. So, a solution was proposed that entailed massive lending to keep non-competitive businesses operating and wages paid. That resulted in even greater inefficiency and made Chinese exports even less competitive.

The Chinese surge had another result. China’s success with boosting low-cost goods in advanced economies resulted in an investment boom by Westerners in China. Investors prospered during the surge, but it was at the cost of damaging the economies of China’s customers in two ways. First, low-cost goods undermined businesses in the consuming country. Second, investment capital flowed out of the consuming countries and into China.

That inevitably had political repercussions. The combination of post-2008 stagnation and China’s urgent attempts to maintain exports by keeping its currency low and utilize irrational banking created a political backlash when China could least endure it – which is now. China has a massive industrial system linked to the appetites of the United States and Europe. It is losing competitive advantage at the same time that political systems in some of these countries are generating new barriers to Chinese exports. There is talk of increasing China’s domestic demand, but China is a vast and poor country, and iPads are expensive. It will be a long time before the Chinese economy generates enough demand to consume what its industrial system can produce.

In the meantime, the struggle against unemployment continues to generate irrational investment, and that continues to weigh down the economy. Economically, China needs a powerful recession to get rid of businesses being kept alive by loans. Politically, China can’t afford the cost of unemployment. The re-emergence of a dictatorship in China under President Xi Jinping should be understood in this context. China is trapped between an economic and political imperative. One solution is to switch to a policy that keeps the contradiction under control through the use of repression.The U.S. is China’s greatest threat. President Donald Trump is threatening the one thing that China cannot withstand: limits on China’s economic links to the United States. In addition, China must have access to the Pacific and Indian oceans for its exports. That means controlling the South and East China seas. As we have previously written, the U.S. is aggressively resisting that control.

Faced with this same problem in the past, Japan turned into a low-growth, but stable, country. But Japan did not have a billion impoverished people to deal with, nor did it have a history of social unrest and revolution. China’s problem is no longer economic – its economic reality has been set. It now has a political problem: how to manage massive disappointment in an economy that is now simply ordinary. It also must determine how to manage international forces, particularly the United States, that are challenging China and its core interests. One move China is making is convincing the world that it remains what it was a decade ago. That strategy could work for a while, but many continue viewing China through a lens that broke long ago. But reality is reality. China no longer is the top owner of U.S. government debt, an honor that goes to Japan. China’s rainy day fund is being used up, and that reveals its deepest truth: When countries have money they must keep safe, they bank in the U.S.China carried out a great – and impressive – surge. But now it is just another country struggling to figure out what its economy needs and what its politics permit.

NEW YORK – The United States may be about to implement a border adjustment tax. The Republican Party, now in control of the legislative and executive branches, views a BAT – which would effectively subsidize US exporters, by giving them tax breaks, while penalizing US companies that import goods – as an important element of corporate-tax reform. They claim that it would improve the US trade balance, while boosting domestic production, investment, and employment.

They are wrong.

The truth is that the Republicans’ plan is highly problematic. Along with other proposed reforms, the BAT would turn the US corporate income tax into a tax on corporate cash flow (with border adjustment), implying far-reaching consequences for US companies’ competitiveness and profitability.

Some sectors or firms – especially those that rely heavily on imports, such as US retailers – would face sharp increases in their tax liabilities; in some cases, these increases would be even greater than their pre-tax profits. Meanwhile, sectors or firms that export, like those in manufacturing, would enjoy significant reductions in their tax burden. This divergence seems both unwarranted and unfair.

The BAT would have other distributional implications, too. Studies indicate that it may hit consumers among the bottom 10% of income earners hardest. Yet it has been promoted as a way to offset the corporate-tax cuts that Republicans are also pushing – cuts that would ultimately benefit those at the top of the income distribution.

Making matters worse, the BAT would not actually protect US firms from foreign competition. Economic theory suggests that, in principle, a BAT could push up the value of the dollar by as much as the tax, thereby nullifying its effects on the relative competitiveness of imports and exports.

Moreover, the balance-sheet effects of dollar appreciation would be large. Because most foreign assets held by US investors are denominated in a foreign currency, the value of those assets could be reduced by several trillion dollars, in total. Meanwhile, the highly indebted emerging economies would face ballooning dollar liabilities, which could cause financial distress and even crises.

Even if the US dollar appreciated less than the BAT, the pass-through from the tax on imports to domestic prices would imply a temporary but persistent rise in the inflation rate. Some studies suggest that, in the BAT’s first year, the new tax could push up US inflation by 1%, or even more.

The US Federal Reserve may respond to such an increase by hiking its policy rate, a move that would ultimately lead to a rise in long-term interest rates and place further upward pressure on the dollar’s exchange rate.

Yet another problem with the BAT is that it would create massive disruptions in the global supply chains that the US corporate sector has built over the last few decades. By undermining companies’ capacity to maximize the efficiency of labor and capital allocation – the driving motivation behind offshoring – the BAT would produce large welfare costs for the US and the global economy.

The final major problem with the BAT is that it violates World Trade Organization rules, which allow border adjustment only on indirect taxation, such as value-added tax, not on direct taxes, like those levied on corporate income. Given this, the WTO would probably rule the BAT illegal. In that case, the US could face retaliatory measures worth up to $400 billion per year if it didn’t repeal the tax. That would deal a serious blow to US and global GDP growth.

So how likely is the US to enact the BAT? The proposal has the support of the Republican majority in the House of Representatives, but a number of Senate Republicans are likely to vote against it. Democrats in both houses of Congress are likely to vote against the entire proposed corporate-tax reform, including the BAT.

The executive branch is also split on the issue, with President Donald Trump’s more protectionist advisers supporting it and his more internationalist counselors opposing it. Trump himself has sent mixed signals.

Disagreement over the BAT extends to business as well, with firms that export more than they import supporting it, and vice versa. As for the general public, low- and middle-income households should oppose the BAT, which would drive up prices of the now-cheap imported goods that these groups currently consume, though Trump’s blue-collar constituents, particularly those who work in manufacturing, may support the measure.

Ultimately, the case for the BAT is relatively weak – far weaker than the case against it. While this may be enough to ensure that it doesn’t pass, there are strong protectionist forces in the US government pushing hard for it and similar policies. Even if the BAT is rejected, the risk of a damaging global trade war triggered by the Trump administration will continue to loom large.

The recent strength in the virtual currency suggests a lack of investor confidence in fiat currencies.

By Michael Kahn.

Pixabay

Analyzing currencies is an exercise in relativity. We can say the U.S. dollar is up, but relative to what?

It may be strong compared to the euro, but is it strong when compared to the Brazilian real? (It’s not, by the way.)

With its recent runup to all-time highs versus the dollar, the cryptocurrency bitcoin shows it’s among the strongest areas of the currency market. This raises two questions. First, is this another bubbly run similar to the one seen in 2013 (see Chart 1)? And if it is a bull market, does that have implications that transcend the mere relative strengths among currencies?

Chart 1

The latter question requires an in-depth discussion that goes far beyond the scope of this column.

However, we can use a few other charts to show that something different is brewing. We’ll get to that in a moment.

As for the first question, the current pace of advance does look quite fast, but it still pales in comparison to bitcoin’s runup four years ago. Granted, back then bitcoin was still a novelty in the financial world and a curiosity, if that, among regular investors.

Technical indicators are not of much help because momentum studies are deep into overbought territory now, as they were then. Indeed, when a market melts up, it becomes dangerous for bulls and bears alike. Mistiming a trade by even one day can result in big losses.

And no matter how crazy a rally looks, remember the words of John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.” We cannot know if and when this rally will end.

All we know for sure is that it is a rally, and people are exchanging U.S. dollars for bitcoins in a big way.

While nowhere near the same pace or magnitude, people are also exchanging fiat money for gold.

This is a bit trickier to see because gold is priced in dollars, and since the dollar is strong versus a basket of major currencies – the U.S. dollar index – the chart of gold itself shows a market languishing for several years. All else being equal, a rising dollar hurts the price of gold.

However, if we take the dollar out of the picture and price the metal using the basket of other currencies, we get a very different picture. For simplicity, since the basket is roughly 50% weighted in the euro, a chart of the SPDR Gold Shares Trust exchange-traded fund (ticker: GLD) divided by the CurrencyShares Euro Trust ETF (FXE) gives us a very similar chart (see Chart 2).

Chart 2

What we see is a rally beginning in 2013 and slowly grinding its way back higher after a sharp selloff.

In fact, it has already recaptured two-thirds of what it lost. More-advanced chart watchers will appreciate that the market regained a Fibonacci 61.8% of its losses, and any additional strength would imply a full recovery is likely.

Let’s get back to what this means for paper currencies. Again, it requires a discussion that transcends the charts but it does give us an idea that alternatives to dollars, euros, pounds, and yen are getting some serious interest.

To be sure, betting against the dollar based on the argument that the Federal Reserve’s quantitative-easing and bond-buying activities would cause it to tank and inflation to soar was a losing game since it began. And even as the Fed changes to a strategy of raising short-term interest rates, the bond market still yields close to generational lows. By standard measures, there is no inflation right now.

That just means the market’s economic fears are so far unfounded. But it does not mean we should ignore any signs of economic changes that might appear. Is the new high in bitcoin that sign? Are the gains in dollar-adjusted gold more than just a curiosity? Both should at least lead to a discussion over the emergence of a new macro trend in the currency markets.

And that’s about all I can conclude from price charts. Right now, the U.S. dollar remains in good shape, at least relative to other traditional currencies.

The Mexican Peso Rally

Before closing, let’s take a quick look at the Mexican Peso, since it has been in the news both before and after the presidential election. Last week, the peso rallied sharply to break out from a small technical pattern and continue its rally from January (see Chart 3).

Chart 3

The peso was shellacked after the election, thanks to then-candidate Donald Trump’s statements on the U.S.’s business relationship with Mexico. While its current rally is strong, and the peso has recovered a Fibonacci 61.8% of what it lost, the situation is much different than it is for gold above.

The peso has been in a bear market since at least 2014. That means the postelection selloff happened in the direction of the major trend, and the current rally is still a short-term rally within a long-term bear market. Nothing has yet happened to change the major trend.

DURING his campaign for the White House, Donald Trump touted a “penny plan” for government spending. This meant cutting the part of the budget that funds day-to-day operations—ie, excluding Social Security, health care, debt interest or defence—by 1% a year. Critics said such cuts were unachievable. Department budgets are already beneath their historical average as a share of the economy. They would have to shrink by nearly a third over a decade, after accounting for inflation, to satisfy the penny plan.That has not deterred Mr Trump. On February 27th the White House announced its headline budget numbers, ahead of a more detailed plan due to appear soon. In his first year in office, Mr Trump is proposing to cut so-called “non-defence discretionary” spending not by 1%, but by more than 10%, relative to current law. The $54bn (0.3% of GDP) this would free up would flow to the defence Budget.Cue incredulity. The part of the budget Mr Trump would cut, which funds things like education, housing and national parks, has already fallen by over 10% in real terms since 2010. Strict spending limits in the Budget Control Act of 2011, sometimes called the “sequester”, caused the dive. These kicked in automatically after Congress failed to pass a more palatable plan to bring down deficits. The sequester was supposed to be so severe that lawmakers would have to strike a deal to avoid it. Cutting budgets by a further 10% would be painful. The White House wants the State Department and foreign-aid budgets to bear much of the burden. But these make up only a small proportion of the federal budget: about $57bn in total (see chart).

Advertisement:Replay Ad

Advertisement

3

The sequester also cut defence spending deeply, which is why hawks like Senator John McCain have been questioning America’s military preparedness. Barack Obama’s last budget proposed a boost to defence spending about two-thirds as big as Mr Trump’s (see chart). A recent paper by Mr McCain argues that an additional $54bn is needed on top of Mr Obama’s figure—for a total boost of $91bn, compared with the sequester.Congress can usually write budgets with a simple majority in both houses. But amending the sequester may require 60 votes in the Senate, and hence bipartisan co-operation. (This happened in 2013 and 2015.) Democrats will never support cuts on the scale Mr Trump seems to want. Plenty of Republicans, too, worry about cuts to the State Department. Mick Mulvaney, Mr Trump’s budget chief, says that he is under no illusions about the budget’s prospects in Congress, recalling that Republicans paid little attention to Mr Obama’s proposals. The budget, he says, was not written for Congress, but for the people.

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.